The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to ensure that as few as possible escaped the common misfortune.
John Kenneth Galbraith
The Great Crash: 1929
I apologize for being out of radio contact of late -- I work on the financial industry and the past few weeks have been, ah, eventful, which is to say, catastrophic.
I won't bore you with the bloody details; others, such as bonddad, have already sliced open the corpse and described the basic anatomy of the crisis, which is depressingly identical to the aftermath of every other speculative bubble since Adam and Eve tried playing the apple futures market.
Bells and whistles aside (such as the fungal growth of a $10 trillion global over-the-counter credit derivatives market, or Wall Street's blind faith in its own ability to transubstantiate subprime mortgages into AAA-rated, investment-grade paper) the only things remarkable about this bubble were how long it lasted and the scale of the recklessness.
Some mistakes look even dumber in hindsight than they did at the time: Like the creation of a parallel depository banking system (a.k.a. the money market mutual fund industry) without any sort of insurance fund (either public or private) and only cursory regulation -- which is roughly like building a 150-story skyscraper with one fire alarm and no sprinklers.
The price tag, we're now told (by the very same people who a year ago assured us the problem was limited to a few low-income deadbeats) is in the neighborhood of $700 billion, although I would suggest doubling that figure -- and then doubling it again -- if you want a more realistic estimate of what this fiasco ultimately will cost the taxpayers. And that doesn't include the indirect costs, such as higher interest rates on the rest of the national debt, higher cost-of-living adjustments for Social Security and other inflation-protected benefits, and the higher federal spending and lost revenues caused by the steep recession the US economy now appears to be heading into.
All this would be bad enough, but the crisis could easily get much, much worse. Today's developments in the financial markets offered a preview (or at least a dress rehearsal) of how the next phase could play out. Some of the highlights:
- Stock prices and US Treasury bond prices both fell. Usually, when investors are bearish on stocks (because of a looming recession, for example) they buy Treasuries, which tend to do well when the economy is slowing and inflation is falling. Today, they sold both -- a sign that investors fear both recession and inflation, the same combination that made the '70s such an interesting time to live through, financially speaking.
- The dollar tanked, falling 2.5% against the euro and 2% against the yen (both tear-your-face-off daily moves, by FX market standards.) This suggests that currency traders and/or foreign investors have looked at the alternatives -- a staggeringly expensive bailout that balloons the US national debt on one hand, or a failed bailout leading to a 1932-style collapse of the US banking system on the other -- and have concluded that, either way, the creditworthiness of the US government (which means the inflation-fighting resolve of the Federal Reserve) is now in serious doubt.
- Prices of oil, gold and other physical commodities leaped, with oil posting a record daily move of almost 15% (a short squeeze in the futures market accounted for part of that melt-up, but only part) and gold rising more than $45 a ounce. These are signs of what the economists like to call "extreme liquidity preference" -- cash hoarding -- except that increasingly, "cash" is being defined as a hard physical asset that investors expect (or at least hope) will provide a reasonably safe store of value. Dollar-denominated assets (even short-term Treasury bills, the traditional refuge in times of crisis) are increasingly seen as not passing either test.
I realize this may sound like financial gobblygook -- the same snake oil doubletalk that Wall Street and its army of whores used to flimflam their way into this mess in the first place. So think of it this way: What happened last week was a giant run on the bank, with people lining up to get their money back -- like that scene in It's a Wonderful Life, except in cyberspace, not Bedford Falls, and with Ben Bernanke and Hank Paulson, not Jimmy Stewart, standing in the electronic doorway and explaining to people that they their money isn't in the bank, because it's been loaned to a hedge fund in London, which loaned it to a Wall Street investment bank, which loaned it to a mortgage banker in Nevada, who stole it and deposited it in a numbered bank account in the Cayman Islands. (OK, so maybe it's not like that scene in It's a Wonderful Life -- it's more like the scene where Jimmy Stewart comes back to find he was never born and Mr. Potter owns the whole town. But you get the idea.)
What we saw today, however, was something different: a dawning suspicion among the customers that the bank is paying them off in counterfeit bills.
If this suspicion takes hold and spreads, it could open up broad new avenues for financial disaster. Up until now, the Fed and the Treasury have been able to use their respective balance sheets to absorb the systemic shock of the crisis. As private institutions have deleveraged (i.e. shed both assets and debts) the government has leveraged up -- expanding its own assets and liabilities, either through the Fed's various emergency lending operations or the Treasury's acquisitions of bankrupt companies (like Fannie Mae, Freddie Mac and the late, unlamented AIG).
So far, so bad (although not far or bad enough, thus the need for another $700 billion in borrowing and lending authority.) But these rescue operations are only feasible because the Treasury is assumed to have unlimited ability to borrow dollars and lend them on to the banks. This is the only reason Uncle Sam could, at the stroke of a pen, insure more than $3.5 trillion in money market funds last week -- and have those guarantees accepted without question in the markets. As far as Wall Street's concerned, there's always plenty more where that came from.
But this assumption, in turn, ultimately rests on the fact that the Treasury is borrowing in a currency that can be created on demand by its bureaucratic doppleganger, the Federal Reserve. Unlike, say, Mexico or Argentina, there is absolutely no chance the US will be forced into default because it can't service or roll over its debts. It's just a question of how much pain (in the form of higher interest rates) the Fed is prepared to accept before it cranks up the electronic printing press.
So far, the Fed has tried very hard not to monetize (i.e. print up new money to pay for) its various bailout ventures. Instead, it has been liquidating its existing portfolio of Treasury securities, essentially swapping them for toxic crap. But that string has now run out; the Fed has been stuffed as full of crap as a Christmas goose -- meaning the Treasury is going to have to go to the bond market and borrow the money for the MOAB (or as some have already dubbed it, the Taxpayer Anal Rape Program). Since Americans don't save nearly enough to buy all those bonds -- not without sending interest rates into the stratosphere -- the bulk of the financing will have to be provided by our foreign creditors, such as the central banks of Japan, China and the major oil exporting countries.
The problem, of course, is that our creditors are already into us for a cool $13 trillion (about 90% of US GDP) and have shown a growing reluctance to lend us more (by using their export earnings to purchase US Treasury bonds and other dollar-denominated assets) as the crisis has worsened.
It's not that they want to blow up the US financial system, mind you -- as the British economist John Maynard Keynes quipped, if you owe the bank $10,000 and can't pay it back you've got a big problem, but if you owe the bank $10 million and can't pay it back the bank has a big problem. Our official creditors (the foreign central banks that have been covering the bulk of our borrowing needs for some years now) certainly understand that they have a big problem, but a lot of them have other big problems -- such as their own market bailouts that need to be paid for and/or serious inflationary spirals that are very tough for them to fight as long as they have to keep expanding their balance sheets to loan us money to support the dollar.
Even worse: private foreign investors appear to be dumping their US assets, meaning our central bank creditors not only have to extend us more loans, they also have to buy up the dollars their own citizens no longer want to own. Even the deepest purse has a bottom, and the point may be approaching where the costs of propping up the world's largest debtor nation (i.e. us) begins to outweigh the benefits.
Or maybe not -- given that a systemic run on the dollar would devastate our creditors as well as us (the People's Bank of China alone holds over $500 billion in dollar assets) and would probably blow their financial systems to kingdom come as well as ours. But the system of financing arrangements that keeps the dollar afloat (which some have dubbed "Bretton Woods II") was under enormous stress even before the bubble popped. Some, such as NYU economist Noriel Roubini (a.k.a. Dr. Doom II) predict it won't survive the crisis, at least not in its current form.
If that happens, and the Treasury can't find buyers for its debt at interest rate levels that a rapidly weakening US economy can afford to bear, the Fed is going to face an excruciating dilemma: Fire up the printing presses to make the dollars to buy the bonds the Treasury can't sell in the private market, and watch inflation and confidence in the dollar go tearing off in opposite directions (the wrong ones in either case) or allow rising interest rates to push the economy even deeper into recession -- potentially undoing all the damage control paid for with the MOAB.
Again, putting econospeak aside, the basic problem is actually fairly simple: As long as the problem is a shortage of dollars (both to restore "normal" liquidity to the markets and make good the banks' losses on toxic mortgages) the Fed and the Treasury have unlimited resources. That's not to say they actually would print an infinite number of dollars to pay for the MOAB, but they could if they had to -- which in turn makes a bailout of this size credible.
If, however, dollars are no longer enough -- because private investors have lost confidence in the currency (or, more accurately, in the Fed's willingness to defend the value of the currency) then the MOAB is no longer credible. The Fed may be able to print dollars on demand, but it can't print oil or wheat or gold or any of the other commodities that can, in a pinch, be used as substitutes for dollars.
At that point, another turn of the systemic screw could only be unwound with the full-out support and cooperation of our foreign creditors -- cooperation which so far they appear reluctant to supply in the quantities needed.
This is why I've always believed that the great American debt-and-consumption binge would ultimately end in a whopping big dollar crisis -- and not before. The US economy is by nature bubble prone, but there are many ways for the monetary powers-that-be to cushion the blow when bubbles burst and inflate new ones to take their place (as the Greenspan Fed proved several times over). Too much political capital has been invested in the model (i.e. asset price inflation as the engine of growth in an increasingly distorted economy) for it to be otherwise.
That being the case, it was probably inevitable that the bubbles would continue to grow in size and destructive force until they finally outstripped even the US government's ability to manage them without triggering a run on the biggest bank of all -- itself.
We may not be there yet. Both the dollar and the commodity prices could stabilize, at least temporarily -- particularly if the Cheney Administration (or should I say the Goldman Sachs Administration?) and the Dems in Congress can quickly reconcile their differences and ram the MOAB through the legislative colon (and up ours). Further disasters are not inevitable -- or at least, they don't have to happen all at once.
But if and when it comes, disaster (the kind that turns financial panics into searing generational memories) will unfold in a string of events that will look very much like what we saw in the markets today -- only on steroids.